Deductions Limits Will Affect Many

By

John D. McKinnon

Updated Jan. 3, 2013 1:24 p.m. ET

WASHINGTON—One of the biggest tax increases in the fiscal-cliff bill is also one of the least understood: a set of limits on tax deductions and other breaks that will hit far more households than the bill's rate increases for top earners.

The bill approved in Congress to avert the fiscal cliff would bring the first major tax increase on high earners in 20 years. Laura Saunders breaks down how new tax increases will impact across different tax brackets. Photo: AP.

Total Return

The bill that cleared Congress Tuesday boosts the tax rate for single filers making more than $400,000 and married couples filing jointly making more than $450,000, or roughly the top 1% of filers.

But provisions that reduce the value of personal exemptions as well as most itemized deductions, including those for mortgage interest and state income-tax payments, will affect about twice as many people since they carry a lower income threshold—$250,000 for singles and $300,000 for married couples.

Those new limits drew complaints from some groups that benefit from deductions, particularly charities that depend on tax-deductible donations. They worry that new curbs on deductions, coupled with other taxes on higher-income Americans, will put a damper on giving.

"We are concerned," said Diana Aviv, president of Independent Sector, a coalition of foundations, nonprofits and other charitable groups. "The big question for us now is, if we are [also] increasing rates on folks…does the combination create a greater disincentive for people to give?"

ENLARGE

The debate foreshadows bigger fights in 2013, when Congress likely will try to overhaul the federal tax code, in part by further narrowing tax breaks.

The new limits are "like another cannonball being fired across our bow," said Jerry Howard, chief executive of the National Association of Home Builders. "Clearly, it shows that the notion of limiting deductions is still one that's being considered by policy makers."

But a J.P. Morgan analyst, Michael Feroli, predicted that the new tax-break limits "should not directly affect…giving to charities or taking on more mortgage debt."

The limits—known as PEP and Pease—were originally part of a budget deal passed by Congress in 1990, and were in effect for more than a decade. The Bush-era tax cuts of 2001 gradually got rid of PEP (which stands for "personal exemption phaseout") and Pease (named for a Democratic congressman who pushed for the deduction limit).

Now the fiscal-cliff bill calls for their return, at least for higher-income people.

The PEP and Pease limits work on the same basic principle, limiting the value of exemptions and deductions for households that exceed a threshold. For example, the Pease limitation reduces a household's itemized deductions by 3% of the amount over the threshold. The reduction can't exceed 80% of the total deductions.

How the Tax Law Might Affect You

See some scenarios for how different groups of people may be affected by the tax changes that will take place under the new law passed to avert the so-called fiscal cliff.

A couple with income of $400,000 average about $50,000 in itemized deductions, according to IRS statistics. Because their income would exceed the $300,000 threshold by $100,000, their allowed deductions would be reduced by about $3,000 to $47,000—potentially boosting their tax bill by about $1,000.

The original proponent of the deduction limit, the late Rep. Donald Pease of Ohio, viewed it as "the best available means…to ensure that nobody could game the system," given the growing number of tax breaks that were being passed by Congress, said William Goold, his former chief of staff. The limit might be viewed now as dated, but "the goal remains as valid now as it did then," he added.

From a political standpoint, the limits allow the Obama administration to achieve its long-sought goal of raising taxes on people making more than $250,000. PEP and Pease represent about $150 billion of the tax increase of about $620 billion over 10 years, making them a key element of the deal.

But some groups that benefit from itemized deductions—charities, for example—worry that the Pease provision might cause donors to be less generous.

A coalition of nonprofit groups, the Alliance for Charitable Reform, said this week that lawmakers should consider excluding charitable-donation deductions from the new limits, in order to protect charitable giving. The coalition also said that lawmakers should take other steps to "continue to preserve the charitable deduction…as we move forward into both tax reform and measures to address the federal deficit."

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